One of the most common protests I hear while talking to advisors and clients is this:
But you’re buying stocks at the top. I want to get in at a good price.
This isn’t just a one-off either. I hear this ALL THE TIME. It feels like a comfortable argument. Why would anyone buy a stock that is extended, at the top of its range, or way above its moving averages? It takes a high degree of psychological resilience to buy stocks (and asset classes) that are making new highs all the time.
As an example, let’s take a look at a stock that we’ve owned in our SRS Aggressive portfolios since the last month of 2009. We bought FFIV at the time because it had exhibited earlier strength and was therefore ranked highly. Fast forward to the beginning of October 2010. The stock’s well up on the year, everything looks great…and then all hell breaks loose. Another company from the same “Cloud Computing” group revises its revenue downwards by a relatively small amount (click here for that day’s MarketWatch reporting).
And just like that, FFIV falls over 12% in one day! When this happens, we’ll get a few calls over the next few days which often go something like this:
Advisor: So when are we selling FFIV?
Dorsey, Wright MM: When the portfolio rules call for a sell. It still has a strong relative strength rank.
Advisor: But the stock lost 12% in a single day! How can you own the stock? I thought you only bought stocks that went up!
And so on. We continued to hold the stock, as it fell in price over the next few weeks. The stock’s relative strength ranking declinded, but not enough to eliminate it from the portfolio. All in all, FFIV fell a grand total of 20% before it hits a short-term low. How many advisors out there are willing to sit through a -20% drawdown without breaking a sweat? Not many. It’s hard for us, too.
Fortunately, our systematic process prevents us from making emotional decisions based on fear and pain. Even though the stock fell -20%, our model did not call for a sell. Did it hurt? Yes. Was it fun? No.
Click to enlarge. Source: YahooFinance
After reporting earnings on Wednesday, the stock is now hitting new highs, having recovered all of that 20% and then some. High relative strength stocks are some of the most volatile stocks on the market, and with price volatility usually comes emotional volatility. To answer the original question, we use a rigorously tested systematic process because it relieves the emotional pressure of making a painful decision.
P.S. from Mike: What J.P. is getting at here is important-the willingness to tolerate psychological discomfort. I spoke at a Morgan Stanley Smith Barney conference this week and suggested that the primary reason that excess returns from value and momentum do not get arbitraged away is because they are psychologically uncomfortable to capture. It is extremely uncomfortable to buy something that is very strong (relative strength) or very weak (value/mean reversion). It is even more uncomfortable to continue holding those positions if they are performing poorly but have not yet triggered your sell discipline. But if you want the returns from a relative strength or value strategy, you have to deal with that discomfort. (Of course, in this case, it’s nice that FFIV has worked out so far. Lots of positions don’t work out so nicely!)
Disclosure: Dorsey Wright Money Management owns FFIV in some of our portfolios & managed products. For a complete list of trades in the SRS Aggressive portfolio over the past 12 months, please direct your request to us at [email protected].
Posted by JP Lee 
